I’d like to extend a special invitation to those of you joining Neil, Roger and me at the San Francisco Money Show: Neil will be hosting the Dining Dozen at one of San Francisco’s finest establishments Friday, July 27, at 7:30 pm.    

The cost for the Dining Dozen is $150 per person. So, if you’d like to join us for martinis, good food, Neil’s wine selections and stimulating conversation, call my publisher’s Member Services at 800-832-2330 to make a reservation for you and a guest. We limit seating to only 12 people to keep the conversation intimate. Call early to secure your place.

Schlumberger and Hedges

Long-time readers are aware that I pay particularly close attention to Schlumberger’s quarterly earnings releases and conference calls. The reason isn’t just that I recommend the stock but that this oilfield services giant operates in just about every imaginable region of the world. Therefore, the calls are always useful to get a bird’s eye view of the industry.

I outlined my basic outlook and expectations for this earnings season in the July 5 issue of The Energy Strategist, A Quarter in Review. I also specifically discussed a handful of companies I’m watching as key indicators for the energy markets this quarter. Schlumberger’s call this morning strengthens my confidence in some of the main points discussed in that issue.

Schlumberger totally blew away analysts’ expectations this quarter, reporting earnings of $1.02 per share on $5.64 billion in revenues. Consensus earnings expectations ahead of the call were for earnings per share of 95 cents on revenue of around $5.53 billion. The stock touched a new high today in the wake of the release.

But, as always, the raw numbers are less interesting than some of the comments made during the conference call. Today, I’ll offer some brief notes on some points I found important and how to play them. I’ll offer a more detailed analysis in an upcoming issue. 

First of all, international drilling and exploration activity remains red-hot; markets outside of North America totally carried the quarter for Schlumberger and once again were the key to the company’s upside earnings surprise. In contrast, North America still looks very weak; that weakness is centered primarily in Canada.

Even more specific, the most vulnerable services function remains pressure pumping. (For those unfamiliar with this terminology, I described the pressure pumping business at some depth in the July 5 issue.)

Schlumberger stated that profit margins have been shrinking in the North America pressure pumping business, particularly in Canada. During the question-and-answer session after the call, management indicated there’s likely more pain to come in this business because many companies sign long-term contracts for pressure pumping services.

The full extent of the pricing erosion won’t become obvious until those contracts start repricing later in the year. Margins for pressure pumping work in 2008 are clearly going to be lower than for this year. This is a business I’ve been worried about for some time, and Schlumberger was the first major oilfield services firm to recognize this developing problem.

It’s also my general feeling that Schlumberger sounded far less confident on the prospects for a near-term recovery in Canadian drilling activity this quarter than it did in last quarter’s call. Such a recovery would be predicated on a sustained rally in US gas prices because much Canadian activity is centered on gas.

The company seems concerned about three key near-term trends in the gas market: rising imports of liquefied natural gas (LNG) into the US, a slower-than-expected decline in Canadian gas production and a backlog of wells.

The first point is that LNG imports in the US have been rising lately despite high levels of gas in storage and relatively depressed gas prices. The fact is that there are limited markets globally that can accept LNG imports, and prices are depressed in Europe as well.

Some of this surplus LNG has found its way into the US. Of course, LNG is still a relatively tiny piece of the US gas market, and any uptick in gas prices abroad would quickly mean less LNG imports.

The second point is that, with the Canadian rig count down 60 percent year-over-year, many pundits—myself included—have been expecting a more meaningful decline in Canadian exports to the US. The reason is that Canadian wells have high decline rates; existing wells can see production decline at an annualized pace of 30 percent or more.

Therefore, producers have to keep drilling new wells to make up for declining production from existing wells. Any drop in the rig count would typically lead to a rapid drop in production.

Management put forth a hypothesis about this during the question-and-answer session. The company believes that some of this may be due to delays of some key oil sands/heavy oil projects in Canada.

The oils sands industry is extraordinarily gas intensive. Natural gas is used to produce the steam that’s a vital part of the production process. Therefore, it’s not so much that production of gas in Canada isn’t falling; rather, demand for gas for oil sands projects has tempered, making more gas available for export to the US.

This, too, seems temporary. With oil prices as high as they are now, oil sands developments are highly profitable. Therefore, these delays are more due to equipment, labor and other shortages than to a lack of demand. If Schlumberger’s informal hypothesis proves correct, I would expect this demand to bounce back relatively quickly.

Finally, there’s the well backlog issue. These are wells that had already been drilled but were simply waiting to be fractured prior to production. Therefore, even as new drilling activity slowed, there was a backlog of nearly complete wells.

As these wells came online, production continued to rise despite the moderating rig count. The company did seem to indicate that this backlog is rapidly decreasing now, so this should become increasingly less of a headwind.

Nonetheless, management seemed to suggest that a recovery in Canada could still be a few quarters away. This isn’t a huge deal for Schlumberger because of the company’s widely diversified operations. The company stated that better-than-projected demand for services in the US helped to offset the extreme weakness in Canada.

And the real growth is overseas. Schlumberger’s red-hot international business can and has been making up for any weakness in North America. Also, Schlumberger stated that it’s performing more specialized, high-tech work in the US; pricing for such jobs is more resilient than for companies involved in the basic pressure pumping business.

Bottom line: Continue to avoid exposure to companies such as BJ Services, Calfrac Well Services and Trican Wells Services. All of these companies have significant exposure to pressure pumping and Canada; there’s real risk that this market won’t see a real recovery until sometime in 2008.

Although Halliburton has some international operations to help offset North American weakness, the company remains a huge player in the North American pressure pumping business. I see significant risk in this stock as well.

Schlumberger’s broad positive comments on US land drilling activity are interesting in light of Canada’s weakness. This may bode well for depressed land driller stocks such as Nabors Industries.

Although I’m not ready to recommend this company in The Energy Strategist, I certainly don’t see much additional downside for the stock. And the company is no longer a North America only player; its international business looks to be on firm footing.

I don’t mean to harp on just the negatives in Schlumberger’s call. Rather, in an industry where just about every market is growing at record pace, North America’s relative weakness continues to stick out like the proverbial sore thumb.

Another interesting market for Schlumberger that appears to be gaining traction is its integrated project management (IPM) business. Basically, this means that an oil or gas producer can contract with Schlumberger to manage an entire project for them.

This is an attractive, high-margin business that received plenty of attention from analysts during the question-and-answer session. The company now has $4.8 billion worth of contracted IPM work.

Schlumberger suggested that it’s getting a good deal of IPM work from national oil companies (NOCs) that don’t have the sophistication or technical know-how to efficiently develop high-tech projects. With the global oil and gas business becoming increasingly technically complex and advanced, I see this business as highly attractive.

Despite all these positives, and Schlumberger’s insulation from the limited weak markets in the world, the stock looks extended near-term. The shares are up nearly $20, more than 30 percent, just since the beginning of June. It seems that the stock has rallied to already price in some of the good news; the risk of a near-term 10 percent correction in the stock is unusually high right now.

Since my recommendation late last year, Schlumberger is up roughly 70 percent and the stock is far above my recommended buy target of $90. Given the near parabolic move in the stock lately, it’s only prudent to take steps to lock in some incremental gains in the stock. I’d suggest taking one of the following actions:

• Take a third of your position off the table, booking the 70 percent gain. Assume you have $12,000 in Schlumberger; I’d recommend selling about $4,000 worth of the stock to book the gain. I’m also raising my stop recommendation on the remaining position to $81.50 to lock in a gain.
• Use options to hedge your risk. If you feel comfortable doing so, consider using the put-protection strategy I outlined in the February 21 issue, All Eyes on Gas. The relevant piece can be found under the subheading “Inevitable Corrections” near the end of that issue.
  
  Specifically, I recommend buying one November 95 put option (SLB WS) for every 100 shares of Schlumberger owned. These options will cost you less than $600 per 100 shares hedged and don’t expire until Nov. 16, 2007.

Two very important points: Don’t do the options hedge unless you own the stock, and don’t buy the puts and sell the stock. Take one option or the other. I prefer the option strategy to the outright sale, but don’t buy the puts unless you feel comfortable with the strategy.

In addition to Schlumberger, several other TES picks have seen big runs lately, are trading above my buy under prices and are overdue a short-term pullback. Topping that list are subsea equipment specialist FMC Technologies and compressor manufacturer Dresser-Rand. To protect your gains in these stocks consider either selling out of a third of your position in each or using the following put hedges:

• Buy one October 90 FMC Technologies put option (FTI VR) for every 100 shares you own. These options will cost you roughly $400 for every 100 shares hedged and expire on Oct. 19, 2007.
• Buy one Dresser-Rand September $40 put option (DRC UH) for every 100 shares of Dresser owned. This insurance will cost you around $230 to $250 for every 100 shares insured. The options expire Sept. 21, 2007.